Derivatives Fundamentals and Options Licensing Course: Hedging with Futures Contracts

Introduction

• Purpose: The primary function of a futures market is to enable risk-averse participants to hedge against price risks by shifting these risks to speculators who are willing to assume them for potential profit.
• Hedging vs. Speculating: Hedging is about reducing or eliminating risk, while speculating involves assuming risk for potential profit.

Key Concepts

• Hedging: Attempting to reduce or eliminate price risk in the market.
• Types of Hedges:
  • Short Hedge: Protects against declining prices if you own or anticipate owning an asset.
  • Long Hedge: Protects against rising prices if you anticipate buying an asset.
• Basis Risk: The risk that the difference between the spot price and futures price (basis) will change unexpectedly.
• Optimal Hedge Ratio: A calculation to determine the number of futures contracts required to hedge effectively.

Short Hedge

• Definition: Used by those who own or expect to own an asset and wish to protect against price declines.
• Example 4.1: A farmer hedges 1,000 tonnes of canola by selling futures contracts to lock in a selling price, eliminating risk from price drops.

Long Hedge

• Definition: Used by those who expect to buy an asset and wish to protect against price increases.
• Example 4.2: A dental supply company buys futures to hedge against potential price rises in silver, locking in a purchase price.

Perfect vs. Imperfect Hedges

• Perfect Hedge: When the basis behaves as expected, resulting in the hedger knowing the net price outcome.
• Imperfect Hedge: When the basis behaves unexpectedly, leading to potential unexpected costs or losses.
• Example 4.3: A hedge becomes imperfect due to unexpected market events that change supply-demand dynamics.

Cross-Hedging

• Definition: Using a futures contract of a different but correlated asset to hedge.
• Examples:
  • Financial Markets: Using CORRA futures to hedge against interest rate changes.
  • Commodities: Using wheat futures to hedge against flour price changes.

Optimal Hedge Ratio

• Purpose: Minimizes basis risk by adjusting the number of contracts according to historical or expected price relationships.
• Calculation:
  • Formula: ( H = \text{Corr}_{PF} \times (\text{SD}_P / \text{SD}_F) )
  • Example 4.5: Calculating optimal hedge ratio for a jet fuel scenario using heating oil futures._

Conclusion

• Hedging Strategy: It is essential to understand the risks involved and the measures to minimize basis risk, such as using the optimal hedge ratio.
• Practical Application: Proper hedging requires careful consideration of market conditions, asset correlations, and the nature of the futures contracts.